Oil rout felt across the board
The oil price crash in the past six months has widespread implications for investors, as the reverberations are felt across the spectrum of asset classes – from commodities to bonds, equities and currencies.
As the decline has gathered pace in the past three weeks, much analysis has been devoted to trying to determine how low oil prices will go and what damage will be done to oil-dependent economies, as well as oil companies. The fall in the oil price is as sharp as the one seen in the wake of the 2008 financial crisis.
Even within the Arabian Gulf states the impact of falling oil prices on the general outlook for economic and markets performance is a mixed picture. Saudi Arabia and the UAE, for example, are thought to have substantial enough fiscal cushions and economic diversity to weather the storm.
“Foreign reserves of more than 95 per cent of GDP and a public debt of less than 2 per cent of GDP would put the government in a comfortable position to gradually adjust to the new norm of lower oil prices and avoid drastic cuts in fiscal spending that would disrupt private sector performance,” says Fahad Al Turki, the head of research at Jadwa Investment in Dubai, of Saudi Arabia’s position.
But some other Gulf states – or at least related investments – are more vulnerable, as reflected in a sharp decline of nearly 10 per cent in the Morgan Stanley Capital International Frontier Markets index. As Neil Shearing, the head of emerging markets research at Capital Economics, points out, that index is dominated by three GCC countries – Kuwait, Oman and Bahrain – as well as Nigeria, although it includes a total of 24 countries. The decline is not only a reflection of sliding oil prices, but the fact that the equity markets in some of these countries had been quite high.
In the global commodity markets, the gloom has well and truly set in.
Last week, the Bloomberg Commodity Index reached its lowest level in more than five years, led lower primarily by another double-digit decline in oil prices over the five days. The losses for oil futures prices since the summer is now more than 40 per cent, with half of the decline coming since the end of November, when Saudi Arabia persuaded fellow Opec members to leave their output target unchanged at 30 million barrels per day, even though it is clear they are producing in excess of 1 million barrels a day more than the market wants.
Is it time yet for oil prices to turn around?
“Trying to call a bottom in this current environment where fear has become a significant driver is not easy,” says Ole Hansen, the head of commodity market research at Saxo Bank. Indeed, the professionals have been getting it wrong, which itself is adding to the market’s downward momentum.
“Hedge funds reduced short [positions] and added to long positions before the latest 10 per cent sell-off as they tried to pre-empt a turnaround. As the sell-off continued the unwinding of these will have caused a considerable amount of additional selling during the past week, not least considering the deterioration of the fundamental outlook,” he says.
A change in that fundamental picture for the oil market is not likely to be apparent for several months, with refineries cutting back oil purchases in the next few weeks because of maintenance work, while supply shows no signs of abating yet, either.
“What is clear is that the strong negative momentum can only be broken if we start to see signs of supply destruction,” Mr Hansen adds. “The only consolation for hard-pressed producers, which are seeing revenues tumbling at the moment, is that the bigger and faster the fall the sooner we could potentially see a normalisation and price recovery.”
The oil price slump is generally considered to be a good thing for the developed economies – akin to a fiscal stimulus, plus it is expected to keep headline inflation in the G7 countries next year to about 1 per cent. Lower oil prices are usually positive for global economic growth. The IMF in its outlook for next year estimated a $20 drop in oil prices would increase global GDP by 0.5 per cent, and possibly by a further 0.7 per cent if it boosted economic confidence.
But for emerging economies as a group it looks like being negative and the most significant economy to suffer is Russia, which has also been hit by Ukraine-related sanctions and has seen the rouble come under sustained selling pressure, losing half its value versus the US dollar this year.
That, in turn, has soured the picture for its economy next year. At the beginning of this month, Russia’s economy ministry changed its forecast for next year from growth of 1.2 per cent to a contraction of 0.8 per cent – meaning recession in the eighth-largest economy in the world. The deputy economy minister, Alexei Vedev, warned the declining rouble would add to inflationary pressures and reduce purchasing power.
There is a danger in thinking that the pain caused to countries such as Russia from the falling oil price will be localised. As David Rodriguez, a strategist at DailyFX, points out, Russia’s debt default in 1998 led to a 30 per cent decline in the JP Morgan Emerging Market Bond Index, even though it made up only 5 per cent of that index.
The risks now that a Russian default could do widespread damage are greater, Mr Rodriguez argues, because emerging market debt has quadrupled in size from its pre-financial crisis peak and (citing the latest Bank for International Settlements quarterly report) is concentrated in relatively small and illiquid emerging market investment vehicles, it is hard to isolate the risk to just the most vulnerable countries.
Russia is the largest but not the only oil-dependent country risk to markets.
“Venezuela is most at risk from lower prices – around 50 per cent of Venezuela’s fiscal revenue comes from oil but it has a dwindling foreign exchange account, at $19.8 billion in 2013, and high spending commitments, with the lowest price of gasoline in the world, at 5 cents per gallon,” says Mr Al Turki. Furthermore, “most of Venezuelan oil output is made up of heavy and sour crudes which are discounted more against benchmark grades, meaning that any oil price decline is felt more sharply by the Venezuelan government.”
While Venezuela seems a far more likely candidate to default than Russia at the moment – with its bond spreads having ballooned out by 1,000 basis points as oil crashed – the collateral damage would be less if it were to do so, says John Higgins, the chief markets economist at Capital Economics. “A sovereign default in Venezuela would probably cause nowhere near as much upheaval as one did in Russia [in 1998], largely because there would be a lot less contagion,” he says. Investors understand emerging markets far better these days, he argues, and there have been widespread improvements in many of their economies, including floating exchange rates, bigger foreign currencies reserves cushions and more stable macroeconomic policies.
Similarly, in individual company investments, there has been a broad reaction, with sharp selling in bonds and shares, though individual companies will have vastly different prospects. The yield on junk rated energy bonds in the US, for example, are approaching distressed levels close to 10 per cent above comparable treasury yields, even though the economics of operators vary widely.
Revenues for all the big oil companies will suffer in the fourth quarter. But, there will be a re-evaluation once the dust settles, even in a lower oil price world.
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Published: December 15, 2014 04:00 AM